WTO and tax subsidies

The WTO pro­hibits the use of tax laws to dis­tort mar­kets for goods, ser­vices and invest­ment. For more than 30 years, these rules have been the occa­sion for fierce trans-Atlantic bat­tles and some debat­able dis­putes deci­sions. In the past 5 years, com­pli­ance action by WTO on the use of direct tax exemp­tions has led to the biggest penal­ties ever approved in a trade dis­pute ‘retal­i­a­tion’ action and laid the ground work for the biggest dis­putes ever brought to WTO. These rules deserve close exam­i­na­tion by trade advo­cates because their appli­ca­tion remains uncer­tain in many respects and their impact will cer­tain­ly grow as they are applied to the terms of com­pe­ti­tion from giant emerg­ing economies like Chi­na and India. First some ter­mi­nol­o­gy: direct tax­es are levied on firms that import and export; indi­rect tax­es tar­get the prod­ucts or ser­vices that they import or export. Direct tax­es include income tax­es, tax­es on cap­i­tal gain, tax­es on pay­roll and the like. Exam­ples of indi­rect tax­es are val­ue-added or con­sump­tion tax­es, or excise duties that apply to the prod­uct or ser­vice sold. The glob­al trade regime makes a debat­able dis­tinc­tion between direct and indi­rect tax­es, each of which is capa­ble of affect­ing the terms of com­pe­ti­tion in trade. In brief (more below) it allows gov­ern­ments to can­cel-out indi­rect tax­es at the bor­der to ‘adjust’ their export impact but pro­hibits such adjust­ments for direct tax­es. There is an appar­ent dif­fer­ence in the dis­tri­b­u­tion of the bur­den of the two forms of tax that seems to jus­ti­fy dif­fer­ent treat­ment under the trade rules. Indi­rect taxes—although levied on the seller—are passed for­ward to the con­sumer in the form of an impost on the price of the good or ser­vice at the point of sale. In fact, the indi­rect tax oblig­a­tion may first be cre­at­ed at the time the raw mate­r­i­al is pro­duced and sold to the proces­sor and passed for­ward all the way along the pro­duc­tion chain until it reach­es the con­sumer of the final tax. But firms can’t always pass the bur­den of indi­rect tax­es on to cus­tomers; it depends on a host of mar­ket fac­tors whether they may absorb some of the costs. Gary Huf­bauer “argues”:http://www.iie.com/publications/papers/paper.cfm?ResearchID=451 that a val­ue-added (indi­rect) tax is sim­ply “… a com­bi­na­tion of a direct tax on prof­its, a direct tax on inter­est and rent paid by the cor­po­ra­tion, and a direct tax on wages.” Econ­o­mists debate whether direct tax­es are passed for­ward in this way to cus­tomers, work­ers and the own­ers of land: at best it’s a grey area and may depend on the cir­cum­stances of each firm. In the short-term, it seems not. But firms with “mar­ket pow­er” (Boe­ing? Air­bus? Microsoft? Intel? Google?) prob­a­bly find it eas­i­er to pass for­ward the impact of the tax­es on their cap­i­tal and most firms may be able to do so in the long-run. The WTO rules, like those of the GATT before them, take the unsur­pris­ing view that if a gov­ern­ment fore­goes or for­gives a tax on con­di­tion that a prod­uct or ser­vice is export­ed, that tax-oblig­a­tion-fore­gone is an export sub­sidy. This rule was spelled out in the ‘illus­tra­tive list’ of export sub­si­dies first attached to the Tokyo Round (mid-1970s) Code on export sub­si­dies, and was sub­se­quent­ly embod­ied in the WTO Agree­ment on Sub­si­dies and Coun­ter­vail­ing Mea­sures (SCM) in 1994. The cru­cial aspect of this rule, as con­firmed by a num­ber of dis­putes deci­sions, is not the actu­al inci­dence of tax that a gov­ern­ment might apply in the case of export activ­i­ties, but any vari­a­tion of the gen­er­al tax pro­vi­sions that cre­ates some ben­e­fit con­se­quent on exports. It’s not dif­fi­cult to see why such a carve-out of export activ­i­ties from the nor­mal tax pro­vi­sions should be con­sid­ered a ben­e­fit to the firm as a con­se­quence of gov­ern­ment action (this is the def­i­n­i­tion of a sub­sidy in gen­er­al terms). So there’s no real con­tro­ver­sy about the rule itself. The con­tro­ver­sy that led to a dis­tinc­tion in the WTO treat­ment of indi­rect and direct tax­es begins twen­ty-five years ago with an his­tor­i­cal ‘under­stand­ing’ reached in the GATT Coun­cil to resolve a brace of dis­putes between the Unit­ed States and a num­ber of Euro­pean coun­tries (France, Nether­lands and Bel­gium) who main­tained ‘ter­ri­to­r­i­al’ tax­a­tion sys­tems and offered tax remis­sions to ensure that no firm paid direct tax twice-over in dif­fer­ent ter­ri­to­ries. The USA, unlike the Euro­pean coun­tries (and unlike most oth­er WTO mem­bers), levies its income tax­es on a world-wide basis, not a ter­ri­to­r­i­al basis. Firms liable for U.S. income tax­es are tax­able on their world-wide income not just their income gen­er­at­ed in or repa­tri­at­ed to the ter­ri­to­ry of the Unit­ed States. How­ev­er, a Unit­ed States law (that has had many forms; it was at first known by the acronym DISC and, in its most recent form has been known as FSC) deferred tax­es on income from, and even­tu­al­ly exempt­ed alto­geth­er, cer­tain export activ­i­ties of for­eign sub­sidiaries of U.S. firms from this world-wide tax lia­bil­i­ty. The Euro­pean coun­tries alleged DISC was an export sub­sidy, and the USA coun­ter­charged that their use of ‘ter­ri­to­r­i­al’ tax­es also sub­si­dized exports, per­mit­ting firms to min­imise tax bur­dens on exports by means of trans­fer pric­ing. The Pan­el reports gave some sup­port to both argu­ments. In the 1981 GATT under­stand­ing that seemed to resolve this legal impasse, the USA and the EC agreed that an export­ing Mem­ber (of GATT at that time) was under no oblig­a­tion to col­lect a tax on an eco­nom­ic process that takes place out­side its ter­ri­to­ry; that GATT did not pro­hib­it mea­sures to alle­vi­ate dou­ble-tax­a­tion and that arms-length pric­ing prin­ci­ples should be fol­lowed when allo­cat­ing income among dif­fer­ent parts of relat­ed firms. This under­stand­ing con­firmed the con­for­mi­ty of ter­ri­to­r­i­al tax sys­tems with GATT and per­mit­ted Euro­pean gov­ern­ments to remit (via a bor­der ‘adjustment&#8217)indi­rect tax­es on export­ed goods because the sales trans­ac­tion in an export takes place out­side its ter­ri­to­ry. By the same log­ic they were able to apply the VAT to imports. For the next fif­teen years, the USAbelieved that the under­stand­ing sanc­tioned DISC (lat­er FISC/FSC) tax exemp­tions and defer­rals that it said were mere­ly repli­cat­ing the effects of a ter­ri­to­r­i­al tax sys­tem. But the USA was unable to sus­tain this argu­ment against the EC’s insis­tence that the rules pro­hib­it­ed tax ‘carve outs’. In 1997 the EC brought a com­plaint under the new WTO dis­putes mech­a­nisms alleg­ing that the FSC offered mas­sive export sub­si­dies. It won the case twice in the fol­low­ing three years lead­ing to two attempts to revise U.S. law that have result­ed in the with­draw­al of the U.S. tax exemptions—in return for $138 bil­lion in tax relief for U.S. man­u­fac­tur­ing. The fail­ure of the first U.S. attempt to com­ply with the WTO rul­ing led to the autho­riza­tion of a mas­sive $4 bil­lion sanc­tion against U.S. exports to Europe (that was not, how­ev­er, levied). This was the largest ‘retal­i­a­tion’ mea­sure ever approved by the WTO, cal­cu­lat­ed to equal the lev­el of the subsidy’s impact on Europe. The his­to­ry of these strug­gles over the impact of WTO tax-relat­ed rules is buried in volu­mi­nous deci­sions of GATT and WTO Pan­els and the Appel­late Body of WTO. But a recent ‘dis­cus­sion paper’ by Pro­fes­sor Michael Lang on the WTO web­site gives an excel­lent overview from a neu­tral per­spec­tive. Dr Gary Huf­bauer, who was an author of the tax com­pro­mise writ­ten into the 1979 Tokyo Round sub­si­dies code has writ­ten a com­pressed, but “com­pre­hen­sive note”:http://www.iie.com/publications/papers/paper.cfm?ResearchID=451 on the his­to­ry of the dis­pute seen from the U.S. side that is well worth read­ing. For even more detail, see his “paper”:http://www.iie.com/publications/papers/paper.cfm?ResearchID=373 propos­ing that the recent WTO Appel­late body rul­ings be used as a basis for fun­da­men­tal reform of the U.S. approach to tax­a­tion of exporters. The sec­ond (2004) attempt by the U.S. Con­gress to change the U.S. law con­tained, how­ev­er, some ‘grand­fa­ther­ing’ pro­vi­sions that allow U.S. ben­e­fi­cia­ries such as Boe­ing, Microsoft, Intel, Cater­pil­lar etc. to con­tin­ue to receive
some ben­e­fits for a peri­od of time. The EC is again chal­leng­ing the U.S. on this point, prob­a­bly with an eye to it’s impact on the par­al­lel dual over Boeing/Airbus sub­si­dies. The Air­bus sub­si­dies dis­pute brought by the USA in Octo­ber, 2004 is still larg­er than the FSC dis­pute. It alleges that Air­bus received more than $15 bil­lion in sub­si­dies since 1967, most­ly in the form of gov­ern­ment grants, soft loans and equi­ty injec­tions. The EC coun­ter­charges, how­ev­er, that Boe­ing has received $23 bil­lion since 1992, part­ly in the form of direct tax sub­si­dies from FSC (con­tin­ued under then grand­fa­ther­ing pro­vi­sions, above). Although the his­to­ry of these dis­putes sug­gests that they are lim­it­ed to tit-for-tat actions across the Atlantic, there is every rea­son to believe that these mas­sive dis­putes will soon involve devel­op­ing coun­tries as well. Many devel­op­ing coun­tries, notably includ­ing Chi­na and India, pro­vide direct tax relief for income from exports or to firms under­tak­ing export activ­i­ties. So-called “for­eign-invest­ed enterprises”:http://us.tom.com/english/435.htm in Chi­na, for exam­ple, that export at least 70 per­cent of their out­put ben­e­fit from a 50 per­cent reduc­tion in their income tax lia­bil­i­ty and more if locat­ed in an export-pro­cess­ing zone.

Peter Gallagher

Peter Gallagher is student of piano and photography. He was formerly a senior trade official of the Australian government. For some years after leaving government, he consulted to international organizations, governments and business groups on trade and public policy.

He teaches graduate classes at the University of Adelaide on trade research methods and the role of firms in trade and growth and tweets trade (and other) stuff from @pwgallagher